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FRM Part II · FRM Exam Part II · Liquidity Risk

Which limitation most clearly applies to an LVaR model that adds half the average bid-ask spread to ordinary VaR?

The main limitation is that a spread-based LVaR captures only exogenous liquidity and ignores endogenous liquidity risk. A large seller's own trades can widen spreads and move prices, especially in stress or with concentrated positions, so actual exit costs may exceed the simple spread add-on.

  1. AIt ignores endogenous liquidity risk, where the firm's own large trades widen spreads and move pricesCorrect
  2. BIt cannot be applied to positions valued at mid prices
  3. CIt always overstates risk for liquid positions such as on-the-run Treasuries
  4. DIt requires the assumption that returns are perfectly negatively correlated across assets

Explanation

A spread-based add-on reflects exogenous market liquidity, the cost faced by a small trader. It does not capture endogenous liquidity, where a large position's sale pushes prices against the seller. This is especially important in stressed markets or for concentrated holdings. The other statements are not true limitations of this approach.

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